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Q3 2021 | Outlook

Michael V. Salm Chief Officer, Fixed Income

Bond markets in flux on rates and inflation outlook

Long-term U.S. Treasury yields slipped and - Putnam term rates rose, as investors mulled growth and inflation. fixed-income views

We believe the environment for fixed-income Shading in the table indicates the

securities remains generally supportive. change from the previous quarter Underweight underweight Small Neutral Small overweight Overweight U.S. government and agency The Fed has adopted a more hawkish tone on U.S. tax exempt rates and higher inflation expectations. Tax-exempt high Agency mortgage-backed securities Collateralized mortgage obligations Non-agency residential mortgage-backed securities -backed securities U.S. floating-rate U.S. investment-grade corporates Global high yield Emerging markets U.K. government Global financial markets were mixed during the second Core Europe government quarter. Fixed-income assets came under pressure Peripheral Europe government periodically due to concerns that rising inflation and Japan government a speedy economic recovery could prompt central bankers to pare back easy money policies. But markets strategy have stabilized as the pandemic shows signs of tailing Favor Favor off in parts of the world and fiscal stimulus continues U.S. dollar versus other Neutral dollar to buoy growth. The rate-sensitive Bloomberg Barclays € l U.S. Aggregate Index rose 1.83% during the £ Pound quarter. Global bonds, as measured by the FTSE World ¥ Yen Index, rose 0.98%. That compares with a gain of 8.55% for the S&P 500 Index. Q3 2021 | Fixed Income Outlook

In mid-June, the signaled that it expects its 2% goal — from 2.4% in March. This comes as the to raise short-term rates by late 2023, sooner than economic recovery is driving consumer prices to the previously anticipated. The Fed also said officials had highest levels in nearly 13 years. The consumer price index discussed an eventual tapering of bond-buying programs. surged 5.4% in June, the fastest rate since 2008, according Some central across Europe and Latin America to the Labor Department. Fed Chair Jerome Powell said have already started to lift rates. But the European Central the spike in prices will likely abate and was largely being Bank has pledged to maintain easy money policies. driven by pandemic-related issues. Against this backdrop, Against this backdrop, President Biden is indicating job growth picked up in June, but the unemployment rate support for a $1.2 trillion spending package to invest in rose to 5.9%. The Fed sees the unemployment rate for the the nation’s infrastructure, adding fuel to the economic year unchanged at 4.5%. recovery. The U.S. economy grew at an annualized rate of 6.4% in the first quarter. ECB pledges to keep policy steady The European (ECB) said in June it plans Yields on longer-dated U.S. Treasuries have broadly to maintain its “very accommodative” monetary trended lower this quarter since peaking in March. The stance. The ECB left the policy rate unchanged but has yield on the benchmark 10-year Treasury note slipped increased the pace of asset purchases while keeping to 1.45% at quarter-end from 1.74% at the end of March, the Pandemic Emergency Purchase Programme (PEPP) while the yield on the 30-year Treasury fell from 2.41% at 1.85 trillion until at least March 2022. Eurozone to 2.06%. The yield on the 2-year note ended the period government bond yields ticked higher during the at around 0.25%. Investment-grade bonds managed second quarter amid expectations of rising inflation, to recover from losses suffered in the first quarter to the Fed’s more hawkish tone on rates, and worries post positive performance. High-yield corporate about the ECB’s stance on policy. Germany’s 10-year did even better, as yield spreads continued to narrow. bond yields, seen as the benchmark for Europe, rose to [Spreads are the yield advantage credit-sensitive bonds a high of -0.074% in mid-May before settling at -0.203% offer over comparable- Treasuries]. at the end of June.

Fed signals shift in easy money policies The ECB in June also forecasted a stronger growth Fed policymakers expect to make two interest-rate outlook and higher inflation in the region. The eurozone increases by the end of 2023, according to the central economy is expected to grow 4.6% this year compared bank’s updated economic projections in June. But they with a 4% forecast in March. Inflation is expected to left the benchmark short-term anchored near spike at 1.9% in 2021, driven by temporary upward zero, where it has been since March 2020. The Fed also factors, before returning to 1.5% in 2022. ECB President pledged to continue buying about $120 billion a month Christine Lagarde said in June that policymakers in Treasury securities and other government-backed are more optimistic about the recovery even as the bonds. The Treasury flattened, and real rates pandemic continued to weigh on the bloc’s economy. rose following the Fed meeting. Overall, we believe the Lagarde added that it was too soon to discuss tapering environment for risk assets remains generally supportive. bond purchases and that premature tightening in rates Considering expectations for sturdier growth, we believe poses risks to growth and inflation. In our view, if there Treasury yields could rise further this year. That said, we are no Covid-19-related hiccups in the fall and inflation think the trend toward higher rates will be gradual as stays elevated, the ECB Governing Council will probably bond investors adjust their growth and inflation outlooks, start debating the end of PEPP in or after March 2022. leading to periods of .

The Fed expects the economy to grow 7% this year from the 6.5% growth estimate in March. Central bank officials have also raised projections for personal consumption expenditure (PCE) inflation to 3.4% this year — above

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Rates sold off on the front end as intermediate- and -term rates rallied and the curve flattened

March 31, 2021 June 30, 2021

3.00% 2.41

2.50%

2.00%

yield (%) 2.06 1.50% asu ry e 1.00%

.S. Tr 0.05 U 0.02 0.50%

0.00% 3Mo 1Y 2Y 3Y 5Y 10Y 30Y

Source: U.S. Treasury Department. Past performance is not indicative of future results.

China seeks more targeted and flexible The world’s second-largest economy is rebounding strongly from the impact of the Covid-19 pandemic, boosted by exports. But the recovery in the consumer spending and factory activity has slowed. The official manufacturing purchasing managers’ index (PMI), a gauge of factory activity, eased slightly to 50.9 in June versus 51.0 in May, data from the National Bureau of Statistics showed. The official nonmanufacturing PMI also dropped in June. ’s economy grew a record 18.3% in the first quarter of 2021 compared with the same quarter last year.

The People’s Bank of China (PBoC) has kept its benchmark lending rate unchanged. The central bank said in June it plans to make policy more targeted and flexible while keeping the economy’s leverage ratio stable. PBoC Governor Yi Gang said consumer inflation will likely stay below the government’s target this year and monetary policy must remain stable. Chinese bonds continue to attract international investors. The 10-year government bonds yielded around 3.075% compared with about 1.308% for the 10-year U.S. Treasury. In recent weeks, the central bank has tried to slow the yuan’s appreciation against the dollar and increase its flexibility.

3 Q3 2021 | Fixed Income Outlook

the overall supply-and-demand backdrop. Our view on Sector views valuation is more neutral, given the relative tightness of yield spreads in the market as of quarter-end. Our Corporate debt: Investment grade and high yield optimism is grounded in the rapidly growing percentage Investment-grade bonds managed to recover from losses of Americans receiving Covid-19 vaccines, sustained suffered in the first quarter to post positive performance. government stimulus, and the continuing recovery of the Within this environment, we have a positive outlook U.S. economy. That said, we continue to closely monitor for the fundamentals and overall supply-and-demand ’ balance sheets and liquidity metrics, with an eye backdrop underlying investment-grade corporate credit. toward risk or a credit-rating downgrade. Risks Our view on valuation is more neutral, however, given the to our generally constructive outlook include any new relative tightness of yield spreads as of quarter-end. Now developments with Covid-19, volatility in commodity that the U.S. economy has largely reopened, investors will prices, and policy missteps from global central banks. have a keen eye on corporate earnings during the next Expectations for defaults have meaningfully improved few quarters. Market participants will also be watching for this year, given the liquidity in the market. any shift in tone by the Fed, should inflation continue to move higher. Trends in the mortgage market High yield rallied in June, along with and In the commercial mortgage-backed securities (CMBS) Treasuries, amid growing confidence that inflation will market, we believe there are attractive risk-adjusted likely prove transitory. Relative to other , investment opportunities available amid an improving high-yield bonds outpaced high-yield bank loans and fundamental backdrop. In our view, borrowers with access the broad investment-grade (IG) fixed-income market, to capital will continue to make investments in properties but modestly lagged IG corporate credit. We have a that were performing well before the pandemic hampered positive outlook for high-yield market fundamentals and their revenue streams.

During Q2, risk assets posted solid excess returns amid widespread reopenings

Excess returns* relative to Treasuries, Q2 2021

2.5

2.0

1.5

1.0

0.5

0.0

-0.5

-1.0 HY bonds EMD U.S. IG corps CMBS Agency MBS Source: Bloomberg, as of 6/30/21. Indexes are unmanaged and do not incur expenses. You cannot invest directly in an index. Past performance is not indicative of future results. See page 6 for index definitions. Excess1 returns are calculated relative to comparable maturity U.S. Treasuries for each index. Excess return does not always mean “outperformance.”

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Near-term inflation expectations are significantly higher Neutral outlook for the euro than they were prior to the pandemic. We think commercial European data continues to improve as lockdowns are properties can better absorb inflation pressures eased and vaccine rollouts improve. The ECB in June said compared with other market sectors, such as corporate its PEPP will continue at a “significantly” higher pace and credit. Consequently, if inflation rises, we believe areas avoided a hawkish surprise. The central bank is in the of the CMBS market may offer compelling relative-value process of finalizing its strategic review, which is expected opportunities. to result in a 2% inflation target. Other big questions on the ECB’s table include the future of the PEPP, which is currently Within residential mortgage credit, given low mortgage set to last until March 2022, and whether to expand the rates, high demand, and a declining inventory of available asset purchase program. In the near term, improving homes, we think home prices are likely to continue rising. growth should continue to be supportive of the euro. But Even with tighter spreads, we have continued to find over the longer term, the ECB’s decisions could weigh on opportunities in investment-grade securities backed by the currency, suggesting a more neutral outlook for the non-agency residential loans, along with legacy residential euro against the dollar. The euro is likely to act as a funding mortgage-backed securities and lower-quality segments of currency for better growth stories elsewhere. the agency credit-risk transfer market.

We believe prepayment-sensitive areas of the market British pound likely to trend higher serve as important sources of diversification. To us, the We believe the United Kingdom remains positioned well prepayment sector offers potential benefits in the event for a domestic and global recovery, fueled by one of the of an economic slowdown, changes in fiscal policy, and/or better-run vaccination campaigns. The Bank of rising interest rates. In our view, many prepayment-sensitive continues a glide path of less dovishness. But with the investments offer attractive risk-adjusted return potential Coronavirus Job Retention Scheme (CJRS) set to end on at current price levels. In terms of investment selection, we September 30 this year, it is unlikely the central bank will are focused on securities backed by reverse mortgages, offer any significant support for the currency. This will leave jumbo loans, and more seasoned collateral. the pound’s movements more reliant on global forces. We expect to see near-term risks and medium-term upside for the sterling. Currency views Japan’s yen likely to depreciate amid global recovery U.S. dollar likely to rise as Fed mulls rate hike The Bank of Japan (BoJ) remains largely sidelined with The United States is set to see its twin deficits widen amid limits on further monetary policy easing. The yen had seen rising fiscal spending and consumer demand for goods and a large repricing on the back of the global recovery but has services. Deficits have been an indicator of dollar direction been range bound since peaking in April. From here, the over past cycles because these deficits need to be funded currency is likely to grind weaker as the global recovery or the dollar needs to fall. With front-end rates pinned close broadens. Yen strength during economic shocks is likely to to zero, flows into U.S. fixed-income markets are likely to be more pronounced going forward, in our view. be hedged. As hedged ratios increase, it leaves the dollar in need of unhedged flows into equities or via inbound mergers and acquisitions. At the June meeting, the Fed unexpectedly pivoted to a more hawkish tone on its policy rate. Labor and future job gains will be pivotal for the Fed as it charts a plan for ending the easy money policies. This makes dollar appreciation against backed by resolutely dovish central banks such as the yen, the Swiss franc, and, potentially, the euro, more likely.

5 Q3 2021 | Fixed Income Outlook

FTSE World Government Bond Index (WGBI) measures the The Fixed Income Outlook represents the insights performance of fixed-rate, local-currency, investment-grade of the collaborative process of our 100+ member sovereign bonds. team and of our senior leadership. High-yield bonds are represented by the JPMorgan Developed High Michael V. Salm Yield Index, an unmanaged index of high-yield fixed-income securities Chief Investment Officer, Fixed Income issued in developed countries.

Michael J. Atkin Japan government is represented by the Bloomberg Barclays Head of Macro and Sovereign Credit Japanese Aggregate Bond Index, a broad-based investment-grade Navin H. Belani benchmark consisting of fixed-rate Japanese yen-denominated Head of Credit Research securities. Albert Chan, CFA Head of Portfolio Construction Tax-exempt high yield is represented by the Bloomberg Barclays

Joanne M. Driscoll, CFA High Yield Index, which consists of below-investment- Head of Short Term Liquid Markets grade or unrated bonds with outstanding par values of at least Brett S. Kozlowski, CFA $3 million and at least one year remaining until their maturity dates. Co-Head of Structured Credit U.K. government is represented by the Bloomberg Barclays Jatin Misra, Ph.D., CFA Sterling Aggregate Bond Index, which contains fixed-rate, Co-Head of Structured Credit investment-grade, sterling-denominated securities, including gilt Robert L. Salvin and non-gilt bonds. Co-Head of Corporate and Tax-exempt Credit Paul D. Scanlon, CFA U.S. floating-rate bank loans are represented by the S&P/LSTA Co-Head of Corporate and Tax-exempt Credit Leveraged Index, an unmanaged index of U.S. leveraged loans.

As of June 30, 2021. U.S. government and is represented by the Bloomberg Barclays U.S. Aggregate Bond Index, an unmanaged index of U.S. investment-grade fixed-income securities. Agency mortgage-backed securities are represented by the Bloomberg Barclays U.S. Mortgage Backed Securities Index, which U.S. investment-grade corporate debt is represented by covers agency mortgage-backed pass-through securities (both the Bloomberg Barclays U.S. Corporate Index, a broad-based fixed rate and hybrid ARM) issued by Ginnie Mae (GNMA), Fannie benchmark that measures the U.S. taxable investment-grade Mae (FNMA), and (FHLMC). corporate .

Commercial mortgage-backed securities are represented by U.S. tax exempt is represented by the Bloomberg Barclays Municipal the Bloomberg Barclays U.S. CMBS Investment Grade Index, which Bond Index, an unmanaged index of long-term fixed-rate investment- measures the market of commercial mortgage-backed securities with grade tax-exempt bonds. a minimum deal size of $500 million. The two subcomponents of the Duration measures the sensitivity of bond prices to interest-rate U.S. CMBS Investment Grade Index are U.S. aggregate-eligible securi- changes. A negative duration indicates that a or fund may ties and non-eligible securities. To be included in the U.S. Aggregate be poised to increase in value when interest rates increase. Index, the securities must meet the guidelines for ERISA eligibility. The Bloomberg Barclays U.S. Aggregate Bond Index is an Emerging-market debt is represented by the Bloomberg Barclays unmanaged index of U.S. investment-grade fixed-income securities. EM Hard Currency Aggregate Index, which is a flagship Emerging Markets debt benchmark that includes USD, EUR, and GBP denom- The ICE BofA 1-3 year U.S. Corporate Index is an unmanaged index inated debt from sovereign, quasi-sovereign, and corporate EM of U.S. investment-grade corporate debt with a remaining term to issuers. The index is broad-based in its coverage by sector and by maturity of less than 3 years. country, and reflects the evolution of EM benchmarking from tradi- ICE Data Indices, LLC (ICE BofA), used with permission. ICE BofA tional sovereign bond indices to Aggregate-style benchmarks that permits use of the ICE BofA indices and related data on an “as is” are more representative of the EM investment choice set. basis; makes no warranties regarding same; does not guarantee Eurozone government is represented by the Bloomberg the suitability, quality, accuracy, timeliness, and/or completeness Barclays European Aggregate Bond Index, which tracks fixed-rate, of the ICE BofA indices or any data included in, related to, or derived investment-grade securities issued in the following European therefrom; assumes no liability in connection with the use of the currencies: euro, Norwegian krone, Danish krone, Swedish krona, foregoing; and does not sponsor, endorse, or recommend Putnam Czech koruna, Hungarian forint, Polish zloty, and Swiss franc. Investments, or any of its products or services.

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